Managing Regulatory Arbitrage: A Conflict of Laws Approach

American International Group (AIG), the very name of this company screams out its US origins. And yet, the traders within the UK subsidiary of this multinational insurance corporation, operating under a French banking license, were able to engage in risk-taking activities that were largely beyond the reach of US insurance and finance regulators. When AIG’s London-based trades fell apart in 2008, the parent institution in the US—and hence the US taxpayers—found themselves on the hook at the rate of $85 billion dollars for decisions made in AIG’s overseas subsidiary.
In the world of financial regulation, national financial regulators are pitted against a globally interconnected financial system. Since 2008, regulators have made a concerted effort to address the national regulatory differences that made AIG’s trades possible in the first place. New rules hammed out at the G20 on such topics as bank capitalization apply to all banks. How have the markets responded? Financiers have simply found ways of transacting through non-bank institutions, the shadow banks, which are not subject to the G20’s rules.
The regulatory challenge posed by both AIG and the shadow banking industry is of paramount importance because the international and conceptual slipperiness of these institutions, which fall beyond the reach of regulators, threatens the sovereignty of nation-states and the well-being of national economies. The technical term for this is ‘regulatory arbitrage’.
The prevailing wisdom is that regulatory arbitrage can be counteracted if only the rules across all legal systems are harmonized. Hence the steady stream of international meetings of regulators seeking to agree on rules for everything from capital adequacy requirements to procedures for unwinding an insolvent bank operating in multiple jurisdictions. The model here is a public international law model: global coordination through agreements hammered out at the international level by representatives of nation-states, who then take those agreements home to be enshrined in national law and enforced locally.
Yet even the proponents of harmonization admit that their track record is unimpressive and their hopes of achieving consensus on many of the most important issues are small. Moreover, as I explain in my forthcoming article, harmonization also has costs: it may actually increase market volatility and instability by allowing for more contagion from one market to the next, and it also sacrifices local differences that may be significant to political communities.
What if international regulatory harmonization at the level of nation-states is an unattainable and in some ways even unpalatable goal? In the article, I argue that there is another possible solution. That solution is to use the rules for coordination enshrined in the conflict of laws (or private international law) to make regulatory arbitrage more costly by thinking in a more robust way about when transactions should be subject to national regulation. For example, rather than just assuming, as the US Supreme Court in Morrison did, that US law only applies to transactions concluded in the US, courts might apply a more complete conflicts analysis to determine that in certain cases, transactions concluded outside the US are nevertheless legitimately subject to US law.

Unlike the harmonization paradigm which pursues legal uniformity, the ‘conflicts approach’ accepts that regulatory nationalism is a fact of life, and sets for itself the more modest goal of achieving coordination among different national regimes. This alternative approach to international regulatory coordination has been developed over centuries. Under the conflicts approach the point is not to define one set of rules that apply for all, as is the case in public international law—the law of international organizations such as the UN or the WTO. Rather, the point is simply to define under what circumstance a particular dispute or problem shall be subject to one state’s law or another.
Thinking in terms of ‘conflicts of law’ changes the debate over global financial regulation because it raises an altogether different set of questions that are largely being ignored. For example: How far does each regulatory jurisdiction extend, and what should be done when these overlap? Or, When should so-called host regulators of a global systemically important financial institution differ to so-called home regulators?

Thinking about conflicts between laws encourages us to more carefully examine how we allocate authority across the existing regulatory regimes. The approach gives us another way of examining, and therefore of challenging, the scope of national, international, and non-state regulation. The article works through a practical example to show how a conflicts approach would manage and mitigate a common kind of regulatory arbitrage in the financial markets. The focus of this piece is on demonstrating the practicality, functional benefits, and normative legitimacy of a conflicts approach. In a companion piece, I plan to take the argument to the next step by showing how it could guide the thinking of regulators seeking to guard against externalities of foreign transactions or in crisis management.

The highly technical quality of the field of conflicts law makes it quite intimidating to some. But I’m interested in what conflicts can do in the sphere of financial regulation precisely because it transforms political questions into technical-legal issues that can be managed within the scope of already existing nearly universal rules enshrined in national law.